What (If Anything) To Do About California Gasoline Price Spikes

Posted by Severin Borenstein on October 12, 2012

Severin Borenstein

Here we go again. A couple refinery disruptions, a pipeline shutdown, and before you know it gas prices in California have jumped more than 50 cents compared to the rest of the country. Soon politicians will be wringing their hands and calling for investigations. Some will blame it on evil oil companies, while others while say it’s due to our insistence on using a different gasoline than other states.

Those calling for investigations will suggest that the refiners are using the problems at a couple refineries as an excuse to raise prices. It’s important to remember that this is a commodity market, so the only way a seller can drive up price is by withholding some supply from the market. That’s what we know happened during the California electricity crisis. Something similar, though much less extreme, could be happening today in gasoline. BUT it is much more difficult to diagnose such behavior in the extremely complex refinery business—where multiple processes are used to produce a variety of different outputs—than in the relatively simple electricity generation business—where natural gas goes in and electricity comes out. In fact, proving such occasional acts of “exercising market power” (as economists call it) from market data is pretty much hopeless in refining. Furthermore, even if we could tell when a gasoline refiner was doing it, as long as they acted alone—not colluding with rivals—it would not be illegal.

On the other hand (just as with the California electricity crisis), the observers who say they are certain this is just the supply and demand workings of a competitive market are making a statement of faith, not analysis. The fact is that production of California specification gasoline (“CARB gasoline”) is very concentrated, with Chevron serving more than 20% of the market and a couple other companies with shares in the high teens. Given the very-low elasticity of demand for gasoline, in the short run, it could very well be profitable for a company to produce a bit less CARB gas in order to drive up prices. It’s not a crazy notion; it’s just extremely difficult to prove and, even then, not a violation of any law. Jim Bushnell, Matt Lewis and I examined these issues in a 2004 working paper. The numbers have changed a bit since then, but the basic analysis is the same.

Other commentators will argue that the problem is for California’s use of its own boutique gas blend, which is not used anywhere else, rather than the federal standard for reformulation. They point out, correctly, that our inability to trade gas with neighboring states mean that there is less buffer when supply is disrupted in California. The problem with this view is that a recent paper by Max Auffhammer and Ryan Kellogg has shown that California blend gasoline has significantly greater health benefits than gasoline that only meets the federal standard, benefits that almost certainly exceed the extra costs we pay.

So what can Californians do to protect themselves from these sudden gasoline price shocks? One answer is to just buck up and deal with it. These California-specific spikes don’t happen that often and they usually don’t last too long. That might be my view if I were confident that the spikes weren’t caused or exacerbated by market power. But the potential that these jumps are not entirely due to real supply/demand imbalances means that a policy to short circuit the spikes at some point could be beneficial.

Steve Stoft and I proposed a solution in a 1999 San Francisco Chronicle op-ed. I think it applies just as well today. California could pass an automatic waiver policy that allows any company to bring in gasoline that only meets federal standards if it pays a surcharge of, say, 25 cents per gallon. The surcharge would be substantially larger than the normal production cost differential, which is generally thought to be 10-15 cents. So, in normal times, no firm would want to exercise this option. But when a supply disruption occurred, and California wholesale prices shot up more than 25 cents above our neighbors, some refiners or marketers would bring in non-CARB gas, and pay the surcharge. The effect would be to cap the price differential at about 25 cents per gallon. It would also short-circuit the incentive of an in-state producer to withhold supply if the impact would just be to trigger imports of non-CARB gas.

What would this do to air quality? Practically nothing. Just as a small shortage drives our prices through the roof, a small quantity of non-CARB gas would drive our prices back down. Even during spikes, the non-CARB gas would be no more than a few percent of the state supply. But these spikes are rare, and usually brief, so the overall impact on health would be miniscule. Still, when it did happen the revenue from the waiver fees could be used to offset the increased pollution. A good place to start would be to buy back more of the old polluters on the road, those pre-1976 cars that in California (for some reason I still can’t fathom) are exempt from emissions checks. That would make the policy a win-win.

Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business and Director of the University of California Energy Institute, where he is also co-Director of the Institute's Center for the Study of Energy Markets.

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